Here,
Michael Taylor (@vilage_idoit) – author at shiftingshares.com – takes a look at how private investors can benefit
from the following piece of academic research on the selling habits of
institutional investors:

Contents

Most money managers are good at buying stocks; however, they are
absolutely terrible at selling them. With this in mind, Akepanidtaworn, Di
Mascio, Imas, and Schmidt’s study found that portfolio managers would be better
off, and in some instances significantly better off, if they sold off their
holdings at random.

It is possible to make money from a random entry trading system as long
as the exits are controlled. However, this is the first piece of research I
have seen that suggests random selling. Indeed, as one extract from the work
puts it:

“While investors display clear skill in buying,
their selling decisions underperform substantially — even relative to
strategies involving no skill such as randomly selling existing positions – in
terms of both benchmark-adjusted and risk-adjusted returns.”

The problem around selling arises because most investors place emphasis
on their buying. They do the research, they study what a stock’s net asset
value is, and they compute complex discounted cash flows on its expected
earnings and cash flows. Much effort goes into the buy side.

However, the other side of the trade is the sell, or the exit. Private
investors often suffer from behavioral biases here such as endowment bias, loss
aversion, and greed. But the study found that many of the professionals were no
different in their actions when it came to selling. They too were restricted by
the same problems and errors that blight private investor portfolios, despite an
increased knowledge of these errors.

“A striking finding emerges: while investors
display skill in buying, their selling decisions underperform substantially –
even relative to random sell strategies. A salience heuristic explains the
underperformance: investors are prone to sell assets with extreme returns. This
strategy is a mistake, resulting in substantial losses relative to randomly
selling assets to raise the same amount of money.”

The problem noted in the above extract comes down to the classic
investing mistake of cutting winners and running losers. The salience heuristic
means we kill winning trades far too early, and, as a direct result, keep the
losers running for longer. Executing a random sell strategy would have removed
this heuristic and bolstered portfolio performance.

Of course, with the fees (in some cases exorbitant fees) many fund
managers take, perhaps their clients would not be pleased to hear that, instead
of selling at the fund manager’s discretion, their money would be better off if
sell decisions were made on a coin toss. On the other hand, people don’t like
to hear that they’ve been wasting their money. As such, many clients would
likely reject the conclusions.

The fact is that most fund managers lack any objective analytical framework
for selling positions, and instead use very subjective rules or gut instinct.
Unsurprisingly, neither of these yield a great deal of success. The study found
that the most common reason to sell was to the buy the next investment idea!

Sample

The data looked at the daily holdings and trades of 783 portfolios that
contained an average value of roughly $573 million. Over 4.4 million trades
were analysed and the study ran from 2000 to 2016, a period covering both
Dotcom and the 2008 Financial Crisis. The length of the study increases its
significance as it removes any doubt over just picking a rosy period in the
stock market. During this period, we have had the largest bull run in history
but two of the worst stock market crashes also.

Testing

Researchers evaluated performance in a clever way. Instead of using a
benchmark as usual, they created a counterfactual sell portfolio, in which a
random security was sold whenever the portfolio manager sold a security in real
life. Sadly, the counterfactual sell portfolio consistently outperformed the
actual fund manager, raising the question: what do we actually pay them for?

What does this mean for private investors?

The implications of this study are clear. As private investors, we need
to be much more aware of our sells and know that we are likely actively
damaging our returns if we aren’t randomly selling our positions. We should
learn about the biases and construct rigid and robust selling plans immediately
after purchasing the stock. Most private investors and fund managers do not put
as much thought into the exit as they do the entry, and this is costing them in
real money terms.

Author: Michael Taylor

You can hear more of Michael’s thoughts at his fantastic ShiftingShares
blog, located at https://www.shiftingshares.com/

The S&P500 has reached new highs again. It’s likely to run on to tackle the 3000 milestone level shortly, where the chart suggests strong headwinds lie. But during the past decade bull run, (assuming we’re still in one) investors have seen this scenario play out positively before - where a big move upward followed with gusto, despite seeming unlikely. Will the third time be so lucky?

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